Finance Test 2

fixed-rate bonds -bonds whose interest rate is fixed for their entire life.
Floating-rate bonds -bonds whose interest rate fluctuates with shifts in the general level of interest rates-the coupon rate is set for an initial period, often 6 months, after which it is adjusted every 6 months based on some open market rate.-some floaters have upper limits (caps) and lower limits (floors)on how high or how low the rate can go
zero coupon bonds -bonds that pay NO ANNUAL INTEREST but are sold at a discount below par, thus compensating investors for the fact that no annual interest is paid in the form of capital appreciation.(these bonds provide capital appreciation rather than interest)
original issue discount (OID) bond -any bond originally offered at a price BELOW its par value
maturity date -a specified date on which the PAR VALUE of the bond must be repaid
original maturity -the number of years to maturity AT THE TIME A BOND IS ISSUED(the maturity at the time the bond is issued)–> the effective maturity obviously declines each year after a bond has been issued. Allied’s bonds had a 15-year original maturity. A year later, the bonds have a 14 year maturity, and a year after that they have a 13 year maturity, an so on.
call provision -a provision in a bond contract that gives the ISSUER the right to redeem the bonds under specified terms PRIOR TO THE NORMAL MATURITY DATE *allow the ISSUER the right to retire the debt prior to maturity-the call provision generally states that the bond issuer must pay the bondholders AN AMOUNT GREATER THAN THE PAR VALUE if they call the bonds. the additional sum is called a CALL PREMIUM< and it is usually equal to one year's interest-some bonds are immediately callable, but in most cases bonds are not callable until after 5 or 10 years after they have been issued.this is known as a DEFERRED CALL, and such bonds have CALL PROTECTION
when do companies call bonds? -companies call its current bonds when interest rates have DECLINED-the company can then sell a new issue of lower-yielding securities because the rates have declined, and it can use the proceeds of the new issue to retire the high-rate issue–> this is known as a REFUNDING OPERATION (it reduces the company’s interest expense)-a call provision is valuable to the firm but detrimental to the long-term investors because they have to then reinvest the funds they receive from the call into bonds with the new and lower rates.
sinking fund provision -a provision in a bond contract that requires the ISSUER to retire a portion of the bind issue each year-require the issuer to buy back a specified percentage of the issue each year–> designed to protect INVESTORS by ensuring the bonds are retired in an orderly fashion*Bonds that have a sinking fund are regarded as being SAFER than those without such a provision, so at the time they are issued, sinking fund bonds have LOWER COUPON RATES than similar bonds without sinking funds.
2 ways an issuer can handle the sinking fund requirement 1. it can CALL for redemption, at par value, the bonds. –> if interest rates have FALLEN since the bond was issued, the bond will SELL for MORE than its par value. In this case, the firm would use the CALL option so it can resell bonds at a lower rate and a higher price.2. the company can buy the required number of bonds on the open market –> if interest rates have RISEN since the bind has been issued, the bonds will sell at a price below par-so the firm will BUY the required number of bonds (because the proce of bonds is BELOW par)
convertible bonds -bonds that are exchangeable at the option of the BONDHOLDER for the issuing firm’s common stock.*convertibles offer investors the chance for capital gains if the stock price increases, and in turn, the issuing company can set a LOWER COUPON RATE
warrants -long-term options to buy a stated number of shares of common stock at a specified price-similar to CONVERTIBLE BONDS, but instead of giving the investor an option to EXCHANGE the bonds for stock, warrants give the holder an option to BUY stock FOR A STATED PRICE*bonds issued with warrants carry LOWER COUPON RATES because of their ability to provide a capital gain if the stock price rises
Putable bonds -bonds with a provision that allows INVESTORS to sell them BACK to the company prior to maturity at a prearranged price*allow INVESTORS to require the COMPANY to PAY IN ADVANCE*if interest rates RISE, INVESTORS will put the bonds back to the company and reinvest in higher coupon bonds.
income bond -a bond that pays interest only if it is earned–> pays interest only if the ISSUER has earned enough money to pay the interest-interest bonds cn therefore not bankrupt a company, but they are RISKIER for an INVESTOR than regular bonds
Indexed (purchasing power) bond -a bond that has interest payments based on an inflation index so as to protect the HOLDER from inflation–> the interest rate of these bonds is based on an inflation index such as the Consumer Price Index, so the interest paid RISES automatically when INFLATION RISES (thus protecting BONDHOLDERS against inflation)
Bond valuation -the value of any financial asset is the PRESENT VALUE OF THE CASH FLOWS THE ASSET IS EXPECTED TO PRODUCE.-for a standard coupon bearing bond, the cash flows consist of the interest payments during the bond’s life plus the amount borrowed (usually the par value) when the bond matures.-for a floating rate bond, the interest payments vary over time-for zero coupon bonds, there are no interest payments, so the only cash flow is the face amount (par value) when the bond matures.
figures -r sub d-the MARKET value of interest on the bond(it is NOT the coupon interest rate, but it can equal the coupon rate at times)-N-the number of years before the bond matures.N declines over time after the bond has been issued-a bond that had a maturity of 15 years when it was issued has N=14 after one year.-INT-DOLLARS of interest paid each year. Coupon rate x par value=dollars of interest payed each year. -M-the PAR, or MATURITY, value of the bond. (this amount must be paid at maturity)
cash flows -cash flows are an annuity (interest payment) of “N” years PLUS a lump sum payment at the end of year N
interest rates and bond prices -an INCREASE in the MARKET interest rate (r sub d) causes the price of an outstanding bond to FALL-a DECREASE in the market interest rate causes the bond’s price to RISE
yield to maturity -the rate of return (INTEREST RATE*) earned on a bond IF IT IS HELD TO MATURITY-EXAMPLE: 14 year, 10% annual coupon, $1000 par value bond at a price of $1494.93, what is the yield to maturity?–> N=14, PV= -1494.93, PMT=(10% x 1000) =100, FV=1000; YTM=5–>WHEN CALCULATING THE YIELD TO MATURITY, ALWAYS INPUT THE PRESENT VALUE AS NEGATIVE-the yield to maturity equals the EXPECTED rate of return only when 1. the probability of default is zero and 2.the bond can not be called.
yield to call -the rate of return (INTEREST RATE) earned on a bond WHEN IT IS CALLED BEFORE ITS MATURITY DATE*if the yield to call is LESS than the yield to maturity, the bond will be called (because this allows the issuing company to save money)
discount bond _whenever the market/going rate of interest rises ABOVE the COUPON rate, a fixed-rate bond’s price will fall BELOW par value , and the bond then sells at a discount-a bond that sells BELOW its par value–> Occurs when the MARKET (going) rate of interest is ABOVE the COUPON rate of interest
premium bond -whenever the market/going rate of interest falls BELOW the coupon rate, a fixed-rate bind’s price will rise ABOVE its par value, and the bond sells at a PREMIUM
par bond -when the MARKET rate of interest is EQUAL TO the COUPON rate of interest, a fixed-rate bind sells at PAR-thus it is a PAR BOND
yield -different from the coupon interest rate of a bond-unlike the coupon interest rate, which is FIXED, a bond’s yield varies from day-to-day depending on current market conditions–> the bond’s YIELD should give an estimation of the rate of return we would earn if we purchased the bond TODAY and held it over its remaining life
discount vs. premium bonds -DISCOUNT BONDS-at maturity, a discount bond must sell at PAR because that is the amount the company will pay its bondholders. therefore, its price must RISE over time to reach par. *discount bonds have a low coupon rate (and therefore a low CURRENT yield) because a discount bond has a coupon rate that is below the market rate, but it provides a CAPITAL GAIN because its price must RISE over time to reach par.-PREMIUM BONDS-its price must equal its PAR value at maturity, and premium bonds occur when the coupon rate is greater than the market rate and when the bond’s price rises ABOVE par value, so its price must DECLINE over time to reach PAR at maturity.*Premium bonds have a high CURRENT yield, but they have an expected CAPITAL LOSS each year because their price has to decline to reach par.
price (interest rate) risk -the risk of a DECLINE in a bond’s PRICE due to an INCREASE in interest rates *an INCREASE in interest rates hurts BONDHILDERS because it leads to a decline in the current value of their bond portfolio*price risk is higher on bonds that have LONGER maturities-the longer the maturity, the longer before the bond will be paid off *INCREASE in interest rates causes a DECREASE in the price of a bond-LONG-TERM securities are exposed to higher interest rate risk-the LONGER a bond’s maturity, the MORE ITS PRICE CHANGES in response to a given change in interest rates
reinvestment risk -the risk that a DECLINE in INTEREST RATES will lead to a decline in income from a bond portfolio (because they are receiving less interest)–> reinvestment risk is high on SHORT TERM bonds-the shorter the bond’s maturity, the fewer the years before the relatively high coupon bonds will be replaced with the new low-coupon bonds.–> people whose primary holdings are short-term bonds will be hurt badly by a decline in rates , but holders of long-term bonds will continue to enjoy the old high rates.
investment horizon -the period of time an investor plans to hold a particular investment
duration -the weighted average of the time it takes to receive each of the bond’s cash flows
mortgage bond -a bond BACKED by FIXED ASSETS (a corporation pledges certain assets as security for the bond)-first mortgage bonds are senior in priority to claims of second mortgage bondsEX; if a company needs 4 million and it sells bonds for 4 million and secures the bonds by a first mortgage on the property, if the company defaults on the bonds, the bondholders can foreclose on the property and sell it to satisfy their claims.
Indenture -a formal agreement between an ISSUER and the BONDHOLDERS-a legal document that spells out in detail the rights of the bondholders and the corporation
debenture -a LONG-TERM bond that is NOT secured by a mortgage on a specific property -debentures can be used by STRONG companies because they do not have to put up property as security for their debt.-debentures can be used by WEAK companies that have already pledged most of their assets
subordinated debentures -bonds having a claim on assets only after the senior debt has been paid in full in the event of liquidation-in the event of BANKRUPTCY, subordinated debt has a claim on assets only after senior debt has been paid in full
investment grade bonds -bonds rated triple B or HIGHER; many banks and other institutional investors are permitted by law to hold only investment-grade bonds
junk bonds -HIGH RISK, high return/yield bonds -as a result of their higher risk and more restricted market(many purchasers are not allowed to buy low grade bonds), lower-grade bonds have higher rates of return
risk vs. return -INVESTORS like returns, and they dislike risk-slope of a risk-return line: a STEEPER like suggest the investor is very AVERSE to taking on risk. a FLATTER line suggests the investor is MORE COMFORTABLE taking on risk-high risk companies must pay higher yields on their bonds to compensate bondholders for the additional DEFAULT RISK -COMPANIES create value by investing in projects where the returns on the investments exceed their costs of capital
bonds vs. stocks -BONDS offer relatively LOW returns, but with relatively LITTLE risk-STOCKS offer the chance of HIGHER returns, but stocks are usually MORE risky than bonds
risk -the chance that some UNFAVORABLE event will occur*no investment should be undertaken unless the expected RATE OF RETURN is high enough to compensate for the perceived RISK
stand-alone risk -the risk an investor would face if he/she held only ONE asset-the risk of an asset is different when the asset is held by itself and when the asset is held as part of a group, or portfolio, of assets.
probability distributions -listings of possible outcomes or events with a probability (chance of occurrence) assigned to each outcome
expected rate of return (r hat) -the rate of return EXPECTED to be realized from an investment; the weighted average of the probability distribution of possible results
probability distribution -the TIGHTER (STEEPER/MORE PEAKED) the probability distribution is, the more likely the ACTUAL outcome will be close to the EXPECTED value, and therefore the LESS likely the actual return will end up far below the expected return.–> the MORE PEAKED the probability distribution, the LOWER the RISK.
standard deviation measures RISK**–> the standard deviation measures the RISK of STAND-ALONE stock. -the SMALLER the standard deviation, the TIGHTER the probability distribution, and the LOWER the risk-the HIGHER the standard deviation, the HIGHER the risk
choice between two investments -if two investments have the same EXPECTED RETURNS and different STANDARD DEVIATIONS, pick the investment with the LOWER standard deviation-if two investments have the same STANDARD DEVIATIONS but different EXPECTED RETURNS, pick the one with the HIGHER expected return
coefficient of variation -another measure of RISK -coefficient of variation=standard deviation/expected return–> it shows the risk PER UNIT OF RETURN –> used to compare two investments when one has the higher expected return, but the other has the lower standard deviation
risk aversion -risk averse investors DISLIKE RISK and require HIGHER rates of return as inducement to buy riskier securities -in a market dominated by risk-averse investors, RISKIER securities compared to less-risky securities must have HIGHER expected returns as estimated by the marginal investor. If not, buying and selling will occur until it does exist
risk premium –> expected return on a risky asset-expected return on a less risky asset -the difference between the EXPECTED RATE OF RETURN on a given risky asset and the expected rate of return on a less risky asset -it represents the additional compensation investors require for bearing RISKIER assets
capital asset pricing model -used to explain how risk should be considered when stocks and bonds are held in a PORTFOLIO–> a model based on the proposition that any stock’s required rate of return is equal to the risk-free rate of return PLUS a risk premium that reflects only the risk remaining after diversification-the risk of a stock held in a PORTFOLIO is usually LOWER than the stock’s risk when it is held alone. because investors dislike risk and because risk can be reduced by holding a portfolio, MOST STOCKS ARE HELD IN PORTFOLIOS
expected return on a portfolio (r hat sub p) -the WEIGHTED AVERAGE of the EXPECTED RETURNS on the assets held in the portfolio–> it is the SUM of the (expected return of each asset in the portfolio times the percent of total of each asset in the portfolio)
realized rates of return -returns that were ACTUALLY EARNED during some past period*actual returns (realized rates of return) usually turn out to be DIFFERENT fro expected returns except for in the case of riskless assets
risk of a PORTFOLIO -the PORTFOLIO’S risk is NOT the weighted average of the individual stocks’ standard deviations. The portfolio’s risk is usually SMALLER than the average of the stocks’ standard deviations because DIVERSIFICATION9what a portfolio accomplishes) LOWERS the portfolio’s risk
correlation –> the tendency of two variables to move together-when two stocks that move COUNTERcyclically to each other(when one falls, the other one rises) are combined in a portfolio, this forms a RISKLESS portfolio.-when stocks in a portfolio are PERFECTLY POSITIVELY CORRELATED and they move up and down together, the portfolio consisting of these stocks would be exactly as RISKY as the individual stocks
diversifiable risk –> the part of a security’s risk associated with RANDOM EVENTS; it can be eliminated by proper DIVERSIFICATION.-AKA company specific or unsystematic risk-(it is risk that is eliminated by ADDING stocks)
market risk –> the risk that REMAINS in a portfolio AFTER DIVERSIFICATION has eliminated all company-specific risk. -AKA NON-diversifiable risk, systematic risk, BETA RISK**-(it is the risk that remains even if the portfolio holds every stock in the market)
market portfolio -a portfolio consisting of ALL stocks in the market
relevant risk –> the risk that REMAINS once a stock is in a DIVERSIFIED PORTFOLIO is its contribution to the portfolios MARKET RISK. -measured by the extent to which the stock moves up or down with the market.*when a stock is held by itself, its risk can be measured by the STANDARD DEVIATION of its expected returns. However, standard deviation is NOT appropriate when the stock is held in a PORTFOLIO
Beta coefficient, b measures MARKET RISK–> a metric that shows the extent to which a given stock’s returns move up and down WITH THE STOCK MARKET*beta measures MARKET RISK-the beta for a PORTFOLIO is the WEIGHTED AVERAGE of the individual securities’ betas -if a stock has a beta of b=2, it is twice as volatile as an average stock (it is TWICE AS RISKY). A portfolio of these stocks would rise and fall TWICE as rapidly as the market.-if a stock has a beta of b=.5, it is only HALF as volatile (risky) as the average stock, and a portfolio of such stocks would rise and fall only HALF as rapidly as the market.-RISKLESS securities have a beta of b=o
average stock’s beta , (b sub a) -b sub a=1*- an average-risk stock is one that tends to move up and down IN STEP with the general market
beta example -if a stock whose beta=1.5 is added to a portfolio with b=1, the portfolios beta and RISK will INCREASE-if a stock whose beta is less than 1 is added to a portfolio with b=1, the portfolio’s beta and RISK will DECLINE-b=.5-stock is only half as risky as an average stock-b=1-stock is of average risk-b=2-stock is twice as risky as an average stock
calculating the BETA of a portfolio -the beta of a PORTFOLIO is the weighted average of the stocks in the portfolio-b sub p=wight of stock(beta of stock)+weight of stock(beta of stock)
figures -r hat sub i-EXPECTED rate of return on the ith stock.-r sub i-REQUIRED rate of return on the ith stock*if the expected rate of return is LESS than the required rate of return, the typical investor will NOT purchase the stock*if the expected rate of return is GREATER than the required rate of return, the investor will purchase the stock because it looks like a bargin-r bar i-REALIZED, AFTER THE FACT return.*a person obviously does not know the realized rate of return at the time they are considering the purchase of a stock-r sub RF-ris free rate of return. Usually measured by the return on T-bonds -b sub i-beta coefficient of the ith stock. the beta of an average stock is b sub a=1-r sub M-REQUIRED rate of return on a portfolio consisting of ALL stocks (which is called a market portfolio)-RP sub m-risk premium on “the market”-it is the additional return over the risk-free rate required to compensate an average investor for assuming an average amount of risk-RP sub i-the risk premium on the ith stock.
security market line -an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities -the SLOPE of the SML reflects the degree of RISK AVERSION in the economy-the GREATER the average investor’s RISK AVERSION-1.the STEEPER the slope , 2. the GREATER the RISK PREMIUM for all stocks & hence the HIGHER the REQUIRED RATE OF RETURN on all stocks*the greater the risk AVERSION, the STEEPER the slope

Leave a Reply

Your email address will not be published. Required fields are marked *